INVESTOR PROTECTION TUESDAY, FEBRUARY 4, 1964 HOUSE OF REPRESENTATIVES, SUBCOMMITTEE ON COMMERCE AND FINANCE OF THE COMMITTEE ON INTERSTATE AND FOREIGN COMMERCE, The subcommittee met at 10 a.m., pursuant to recess, in room 1334, We are glad to have you with us, Mr. President, President Funston of the stock exchange. I feel at this time on behalf of the subcommittee that I should make a few opening comments before we start with these hearings. Following Mr. Funston's last appearance before this subcommittee, two things occurred in quick succession, each involving a fundamentaĺ aspect of the New York Stock Exchange. Mr. Funston testified here on the afternoon of Wednesday, November 20. On the same day, his stock exchange announced the suspension of two of its members for failure to meet the exchange's capital rule. At the time he was testifying, the subcommittee did not know that this had occurred. On Friday, November 22, following the President's assassination, the stock exchange suspended all trading more than an hour before its normal close. The suspension of these members, one of whom was so insolvent that the exchange made arrangements to cover his obligations to his securities customers, sharply again poses the question of just what is the adequacy of the protection that a customer may have who leaves any cash or securities with a broker-dealer. The fluctuation of the stock exchange market prices in the trading between 1:41 and 2:07 on the afternoon of November 22 after the President's assassination and the trading when the exchange reopened on November 26, sharply again poses the question of just what is the role of the specialist in auction markets, and what is the adequacy of the protection than an investor has when he participates in that market. Neither question is a new one. These questions concerning the protection of customers' credit balances and securities and concerning the role of the specialist and segregation of the broker-dealer functions have been around since the passage of the act 30 years ago. They were subjects of study from 1935 to the recent special study of the Commission that was made at the direction of the Congress. Both the Commission and the New York Stock Exchange indicated last Novem ber 20 in testimony here that they wished to make these the subject of further study. Whatever might have been the attitude of this subcommittee on November 20 concerning this further putting off of the coming to grips with these two very basic features of the stock exchange system, it would seem to me that the stock exchange actions of November 20 and of November 22 can do nothing less than lead to a most insistent demand that something definite be done in this field to insure investor protection, and that this something be done right soon. This is the reason, Mr. Funston, that we requested you to return to discuss these and other matters. Indeed, it may be appropriate at this point to include in the record an editorial in the New York Times of January 29 calling upon Mr. Funston to give some definite answers concerning the specialist, and an editorial in the Washington Post of January 2 calling for something to be done for the protection of customers' balances with brokers. If there is no objection, I will at the appropriate time insert these two editorials in the record. (The editorials follow:) [From the Washington Post, Jan. 2, 1964] PROTECTING CUSTOMERS One aspect of the great vegetable oil swindle that has been accorded scant attention is the inadequacy of the laws and regulations drawn to protect the cash balances and securities which brokerage houses hold in custody for their customers. When Ira Haupt & Co. failed after it became hopelessly enmeshed in the futures speculations of Anthony De Angelis, many of the firm's customers were unable to withdraw their cash balances or take possession of paid up securities that were held in "street" name (registered in the name of Haupt). The members of New York Stock Exchange worked out a plan under which $12 million were made available in order to free the assets of Haupt's customers, and to date it has paid out more than $6.7 million. But in spite of this prompt action, many of Haupt's customers have suffered losses for which they will not be reimbursed. The dividends on securities held in street name was immobilized for periods of a week and upward, and many investors were unable to trade during a period in which there were opportunities to make considerable profits. Haupt's bankruptcy underscores two weaknesses in the provisions of the Securities and Exchange Act. As a consequence of the custodial functions which the Nation's brokerage houses perform, they currently hold about $1.2 billion in "net free credit balances"-the funds from the sales of securities, dividends. and interest which are in excess of debts due from customers. These free balances are an important source of working capital, and there is little doubt that brokerage fees would be much higher in their absence. But the law makes no provision for protection of free balances in the event of bankruptcy. Consequently the "Report of the Special Study of Securities Markets" recommended that brokerage houses be required to maintain cash reserves of 15 percent against customers' free balances, a principle which has worked well in the commercial banking industry. And the study also urges that customers be fully informed that their balances are being used by the firms holding them and that they are vulnerable in the event of insolvency. There is also a danger because the law is not clear as to whether a broker may hypothecate-pledge against a loan-a fully paid security without the consent of his customer. And where a blanket consent is obtained, hypothecations cal be made without informing the customer. Although the organized exchanges have done a creditable job in protecting the public when their members have been bankrupted, the Security and Exchange Commission Act should nonetheless be amended to provide adequate reserve against customers' free balances and tighten rules governing the hypothecation of securities by brokers. [From the New York Times, Jan. 29, 1964] DISORDER IN THE MARKET Specialists of the New York Stock Exchange, who are charged with maintaining orderly markets, turned in a mixed performance on November 22, 1963— the day that President Kennedy was assassinated. An investigation of their activities by the Securities and Exchange Commission shows that some specialists contributed to the extremely disorderly conditions that took place in the 30 minutes that the exchange remained open following the news of the shooting in Dallas. Its findings reveal that specialists dumped shares on the market ahead of the public, which led to a nosedive in prices and was hardly consistent with the claim by the New York Stock Exchange that specialists play a vital role in maintaining stability. Keith Funston, the exchange president, acknowledged that "not all specialists acted alike," observing that “some people do not perform as well as others in a crisis." But he neglected to mention that the ability of specialists to provide stability depends to a large extent on their financial resources, which in many cases are inadequate. In Mr. Funston's view, specialists did a good job simply because they ended up buying more shares than they had sold. Specialist purchases do not constitute a true measure of their performance, for it is quite possible to play a destabilizing role and still increase commitments. Mr. Funston also clouds the issue by suggesting that the responsibility of specialists can be set aside in a crisis, which is precisely the time when their stabilizing function is most needed. Even then there is no expectation that specialists can prevent panic or halt a decline. Specialists could be wiped out if they tried to stem a selling wave. But they are supposed to provide a temporary cushion when there is a large gap between supply and demand. And they have a responsibility to avoid adding to any selling or buying pressure. This limited responsibility demands that specialists have adequate financial resources. It also requires the exchange to strengthen its own supervision, with tougher disciplinary penalities against specialists who contribute to disorder. The problem cannot be explained away simply by saying that there will never be another crisis like November 22. There are bound to be new crises that will test the nerves and purses of the specialists. Mr. STAGGERS. I trust I may be indulged in making the parenthetical remark that in view of the expressions both editorial and reportorial hitherto made by the Times and the Post concerning this subcommittee's zealousness in seeking to protect investors, I find their newly expressed position of considerable interest. As I wrote you, we wish to know just what is involved in this Haupt cause, the steps which you have taken to remedy the situation, and the steps you have taken, or propose to take, or suggestions for legislative action which will enable you to provide adequate protection in the future. I also wrote you requesting that you discuss the Commission's report on the activities of the specialists on your exchange following the assassination of the President and that you give us a clearer picture than you presented last time of just what action the exchange intends to take and what action the exchange and the Commission together may take as a result of the deliberations in this field which have been going forward now for some time. In addition, I expressed the desire that you be able to comment briefly on the position of the exchange with respect to the quetion of Commission authority to issue the proposed rule 17a-8 to require every national securities exchange to file with the Commission any proposed notices in the exchange's constitution, bylaws, or rules 3 weeks in advance of their being adopted by the exchange. We are pleased to have you here today, and I know that you welcome opportunity to speak not only on the specialist subject, but also the on the subject of the Haupt Co. insolvency and what you are doing to protect the securities customers even though it appears that in this instance much of the trouble stems from transactions in the commodities markets. In this connection, I cannot but be reminded of your comments on June 29, 1961, when you appeared before this subcommittee to testify on House Joint Resolution 438, which directed the Securities and Exchange Commission to make the study we now are considering. I believe this description of the duties and responsibilities of the New York Stock Exchange in the carrying out of these self-regulatory funetions under the Exchange Act is so clearly germane that it here should be repeated. Mr. MACK. What is the extent of your jurisdiction in the matter of disciplining your members? Mr. FUNSTON. It is very broad. When the exchange was first Mr. MACK. I would like to further ask if it goes beyond the actual operation of the exchange? Mr. FUNSTON. Under the original constitution of the exchange, when it was set up in 1792, the purpose of the exchange was to promote just and equitable principles of trade, and I think the other phase was to provide for high standards of business conduct. When a man comes and signs the constitution of the exchange, a member. he agrees to abide by these rules, and the exchange can, by invoking any one of these things exercise whatever discipline is necessary to bring about compliance with these stands. So our power is very broad. It is generally recognized. The members sign the constitution agreeing to it when they buy a seat on the exchange, and the same rules apply to all of the allied members of a member of the exchange. Mr. Mack then asked of you: Then it would include other activity— and you replied Yes, sir. Any member of the New York Stock Exchange is responsible to the exchange for the performance of just and equitable principles of trade in any line of business in which he is engaged. This wide scope of exchange powers and duties under its constitution and rules, is precisely the reason, as you know, that House Joint Resolution 438 was couched as it was, for this scope encompasses much more than the field covered by the act, itself. Mr. Funston, before you proceed, I believe that I shall here insert in the record my letter to you of January 27. That shall be inserted in the record. (The letter follows:) Mr. KEITH FUNSTON, HOUSE OF REPRESENTATIVES, COMMITTEE ON INTERSTATE AND FOREIGN COMMERCE, President, New York Stock Exchange, DEAR MR. FUNSTON: It is my understanding that the date of February 4 has been confirmed with you for your return to present additional testimony to the subcommittee which is considering the special study made by the Securities and Exchange Commission into the adequacy of the rules of the securities exchanges and the recommendations of that study and of the Commission as contained in H.R. 6789 and H.R. 6793 for legislative action. As you know, on the date of your previous appearance here in November, you released but did not discuss with us at that time the notice of suspension of two members of the exchange for overextension in the commodities market. Indeed, in view of the ramifications that subsequently developed concerning the activities of one of these firms, it probably would have been premature at that time to have engaged in any extensive discussion of the problem. I am sure by this time, however, you are much more conversant with the problem of protection of customers' securities and credit balances as well as of exchange examination of members' financial position, and now can give us as requested of you by Chairman Harris in December, a more detailed presentation of just what is here involved, the steps which you have taken to remedy the situation, and the steps you have taken, or propose to take, or suggestions for legislative action which will enable you to take, to provide adequate protection in the future. In addition, as we all are too regretfully aware, following your previous testimony there occurred the tremendous fluctuation in stock market prices following the assassination of the President. What the activities were of the specialists on your exchange in this fluctuation has now been suggested to us by the Securities and Exchange Commission on the basis of a report on the specialists in 25 securities. I understand that a copy of this report and the Commission's memorandum on the subject was made available to you by the Commission last week. It is my wish that on your return next Tuesday you also might discuss this subject and give to us a clearer picture than you presented last time of just what action the exchange intends to take and what action the exchange and the Commission together may take as a result of the deliberations in this field which have been going forward now for some time. In addition, I trust that you also may be enabled to comment briefly on the position of the exchange with respect to the question of Commission authority to issue the proposed rule 17a-8 to require every national securities exchange to file with the Commission any proposed notices in the exchange's constitution, bylaws or rules 3 weeks in advance of their being adopted by the exchange. This is a subject which I understand you discussed with Chairman Harris last December and is also the subject of a letter of inquiry I made of the Commission several weeks ago following the press announcements of the Commission's proposal, and is commented upon by reply dated January 22 which I received from Chairman Cary of the Commission. It is my purpose to include this comment by the Commission in the record when we reconvene next week but in anticipation of that, I am enclosing a copy so that you may the better present your comments in this regard. Sincerely yours, HARLEY O. STAGGERS, Chairman, Subcommittee on Commerce and Finance. Mr. STAGGERS. So that we might have a full discussion this week of the specialists activity on November 22, I have inserted previously in the record my December 2 request of the Commission for a study of what happened on the day the President was assassinated and the Commission's reply to me of January 21. Also for purposes of a full discussion this week, I here shall insert in the record my query of the Commission of January 17 concerning the source of its authority to require the exchanges to file rules with it in advance of their adoption in view of the special study position that the Exchange Act did not so provide, and the Commission's reply of January 22. (The letters follow:) HOUSE OF REPRESENTATIVES, COMMITTEE ON INTERSTATE AND FOREIGN COMMERCE, Hon. WILLIAM L. CARY, DEAR MR. CHAIRMAN: The Wall Street Journal for January 10 carries an article to the effect that the Commission is about ready to adopt a regulation which will require the New York Stock Exchange and all other securities exchanges to notify the Commission of proposed changes in their constitutions, rules, and bylaws 3 weeks before the exchange themselves act on them. In this connection, I note on 28-738-64-pt. 2——26 |